Automated Market Making

Traditionally, a market maker is a firm or individual who actively quotes two-sided markets in a security or tradable financial instrument. Market makers provide bids (buys) and offers (sells) along with the market size of each. This way, traders have a clear indication of the size and direction in which they can execute a transaction. The most common type of market maker is a brokerage house that provides liquidity to customers. However, DeFi allows any investor to facilitate market-making using smart contracts without a central “institution”. 

AMM’s are one of DeFi’s answers to traditional, centralized finance market-making. AMM’s are the transacting mechanism that live within liquidity pools. AMM’s are designed to algorithmically adjust prices of a token pair in a liquidity pool, based on the demand for one or the other token. Price adjustments reflect a goal of keeping the ratio of any token trading pair in a liquidity pool at 50:50.

AMM’s are a key innovation in the DeFi ecosystem. In a trust-minimized setting, DEX protocols had to figure out a way of smoothing out token pair price volatility, while also maintaining significant liquidity. AMM’s, along with order book mechanisms are two of the prevailing ways in which DeFi trading occurs on DEX’s. 

Providing liquidity to a pool in which the transactions are governed by an AMM is not without risks. Impermanent loss is one of the risks born of providing liquidity to a pool with an AMM transaction mechanism. Impermanent loss occurs when the price of a token pair changes over time versus the price when deposited by a liquidity provider. However, liquidity providers are compensated for this and other risks by participating in the transaction fee revenue stream from the liquidity pool.

AMM’s have provided a way to remove trusted 3rd party brokers from the exchange. DeFi is predicated on the minimization of trust in centralized 3rd parties, so AMM’s, order books and other innovations have provided a trading venue in which smart contracts can carry out execution orders with each other and not be subject to abuse from centralized entities that might otherwise abuse their position. 

However, risks like impermanent loss and other risks are still evident at DEX’s. While impermanent loss is specifically accounted for by sharing in transaction revenues, other risks like smart contract risk are existential, yet not well understood. AMM’s can be lucrative for LP’s, but given DeFi’s nascent stage, there are still many unknowns with regards to the risks involved in these types of trading systems. Liquidity providers should be fully aware of the terms of the liquidity pool they are joining and understand which risks they are being explicitly remunerated for and which risks they are not.